The stock market may be ahead of the economy. That suggests a crash is more likely than a second recession.
There are many ways to value equity markets. A simple one is to compare an index to nominal gross domestic product. What ratio counts as high is a matter of debate, but 1995 is a good starting point. The Dow Jones industrial average first climbed above 4,000 in February 1995, which was then almost 50 percent above its 1987 peak. It was 38 percent below the level of December 1996, when Alan Greenspan warned of irrational exuberance.
If the market’s value had increased in line with nominal G.D.P. since 1995, the Dow would be 105 percent higher, at 8,200 today. If that sounds low, consider that inflating the Dow’s bear market low of 777 points in August 1982 gives it a current level of 3,600.
Even after its recent decline, the market remains far above these levels. The performance certainly owes nothing to superior economic prospects. Rather, ultralow interest rates together with increased leverage inflated corporate profits over the years.
In addition, modern communications technology has enabled multinationals to profit from low-cost global sourcing of labor. Finally, money-supply expansion, with the St. Louis Fed’s broad money-supply measure up 262 percent since 1995 compared with the G.D.P.’s 105 percent increase, has inflated all asset prices.
Interest rates must eventually rise, to prevent inflation and the decapitalization of the United States through low savings and capital outflow. This will raise the cost of capital compared with labor, which would put millions back to work. Normalization need not cause a recession, although it may slow growth in some emerging economies.
But the return to conventional monetary policy would deflate the asset bubble and reduce corporate profits. That’s almost bound to cause a major bear market in stocks, with the Dow heading toward 3,600. Investors, both individual and institutional, will squawk, but those newly restored to employment may rejoice to see, in Churchill’s words, “finance less proud and industry more content.”
Education Battle
Spring is in the air in Santiago, but the Chilean winter is still in season. Huge street protests over education are expected to resume on Thursday. As easy as it may seem to lump these with unrest elsewhere, Chile’s unrest is different. Fundamentally, it is a test of the economic model that has made the nation Latin America’s shining star.
Chile’s educational system reflects the country’s philosophical preference for private, market-based — rather than public — solutions to social and economic problems. After the brutal dictatorship of Gen. Augusto Pinochet, Chile embarked on a free-market path unlike any of its neighbors’.
This has mostly served Chile well. In 1990, per capita G.D.P. stood at $5,000 a year, on a purchasing power parity basis, in line with the rest of Latin America. Today it’s close to $20,000, some 50 percent ahead of the region, calculates Banchile, a brokerage firm. In that sense, the education debate is a developed world problem. The question isn’t whether Chileans go to school, but rather the quality of instruction they receive.
Yet here the Chilean model hasn’t delivered, in ways that could hamper future growth. The country ranks well below the average of members of the Organization for Economic Cooperation and Development in reading, math and science scores, despite households shouldering more of the cost of education than in any other nation. Growth in productivity has been declining for years. Anecdotally, employers complain of a work force unsuited to their needs.
It’s hard not to see Chile’s application of free-market principles to learning as part of the problem. It has created a stratified system where fewer than half of high school students attend public schools because of their low quality. And despite Chile’s financial gains in the post-Pinochet era, the government has been slow to add new public universities.
As a result, protesters want to abolish the profit motive entirely from education. For the center-right government of Sebastián Piñera, the country’s billionaire president, that would be a repudiation of the laissez faire principles on which Chile’s success is based.
But polls show most Chileans favor educational overhaul — and that Mr. Piñera is the least popular Chilean leader since Pinochet. Put it all together, and the price of thawing the Chilean winter looks evident: sacrificing a wee bit of free-market ideology.
MARTIN HUTCHINSON and ROB COX
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